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How Some Emerging-Market Investors Actually Made Money

In a rough year for emerging markets, some of the most treacherous trades are paying off

One emerging-markets debt fund outperformed by buying risky bonds at the right time. Its holdings include bonds sold by Brazilian oil company Petroleo Brasileiro SA, which is mired in a corruption scandal.
Photo:
ueslei marcelino/Reuters

In a rough year for emerging markets, some of the most treacherous trades are paying off.

Bonds issued by Latin American oil companies, Ukrainian banks and Chinese real-estate developers are among the best-performing assets in developing economies in 2015.

Fund managers who snapped up these battered bonds—and other assets deemed risky even by the standards of emerging-market investors—are delivering positive returns while benchmarks languish in negative territory.

“We’re not afraid of going into these risky places,” said Yong Zhu, a portfolio manager at $6.4 million DuPont Capital Emerging Markets Debt fund. “It’s always possible to find countries or companies that have a good chance of surviving.”

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Mr. Zhu’s fund has outperformed other emerging market funds in part because he bought risky bonds at the right time. He also benefited from being in bonds instead of emerging markets stocks, which have gotten hit harder this year.

Still, risky wagers of all types are still vulnerable to factors that could send emerging markets tumbling again: a downdraft in commodity prices, signs of a deepening slowdown in China and greater likelihood of a rate increase by the Federal Reserve.

But fund managers are trying to manage those risks by staying nimble, rather than holding positions for an extended period which could be hurt by sudden market downturns.

They also are spreading their bets across many industries and countries and sticking to dollar-denominated bonds, which allow them to sidestep other currencies’ weakness that erodes returns.

Mr. Zhu’s fund holds dollar-denominated bonds sold by Brazilian oil company
Petroleo Brasileiro SA,
which is mired in a corruption scandal. He also has exposure to banks in Ukraine, which recently reached a restructuring deal with its creditors, and Chinese real-estate developers, which analysts say are especially vulnerable to the country’s economic slowdown.

The fund is up 7.7% this year as of Thursday, making it the second-best performer among the 403 emerging-market bond funds tracked by
Morningstar Inc.
The average fund is down 3.6%. Only about one-third are in the black.

The $27 million Ashmore Emerging Markets Short Duration fund is the top performer among the emerging-market bond funds tracked by Morningstar.

So far this year, it Is up 8.7%, beating the short-term
J.P. Morgan Corp
orate Emerging Markets Bond Index.

The fund, which typically invests in bonds with maturities of one to three years, bought debt issued by energy producers and oil-producing countries during the commodity rout at various times earlier this year.

At the end of September, the fund’s top holdings included bonds issued by state-owned oil producer Petróleos de Venezuela SA that mature this year and next.

Many investors question PdVSA’s ability to repay its debt because the government of Venezuela is struggling with dwindling revenues and foreign-currency reserves due to low oil prices. But PdVSA repaid a $1.5 billion bond on Oct. 28, boosting prices for all Venezuelan bonds.

“If you are buying bonds that mature in six months down the road, you have pretty good visibility,” said Christoph Hofmann, global head of distribution at Ashmore Group, which has $51 billion of assets under management.

The PdVSA 2015 bonds traded as low as 71.25 cents on the dollar in January, but matured at par last Wednesday, according to MarketAxess. That represents a gain of 40%. In contrast, the J.P. Morgan dollar-bond index was up 2.8% for the year through Thursday, while an index that tracks bonds denominated in emerging-market currencies was down 12%.

Jonathan Kelly, who runs the Fidelity Series Emerging Markets Debt Fund, with $1 billion under management, bought dollar-denominated corporate debt in Russia, where he favors telecommunications and oil-and-gas companies.

Russian firms’ bonds sold off in the second half of 2014 amid worries that U.S. sanctions would make it harder to refinance their debt, Mr. Kelly said. But as supply dried up, existing bonds grew in value, he said.

“This year, the narrative has changed,” Mr. Kelly said about Russia. “Although sanctions still exist, there seems to be stability in the Ukraine situation, and the sanctions talk is less severe than it was.”

Investment managers as a group have become more cautious. The average cash position for the 120 top emerging-market equity funds tracked by Copley Fund Research rose to 4.2% in September, the highest level since June 2012. The amount of cash held by bond funds also rose in recent months, according to Morgan Stanley.

Diversification also helps in tough times. The JOHCM Emerging Markets Small Mid Cap Equity fund has about 110 stocks in its portfolio, more than what it normally holds, according to portfolio managers Emery Brewer and Ivo St Kovachev. Shares of some smaller companies will benefit from a positive growth outlook for the individual firms even if economic headwinds buffet the broader market, they said.

The fund has risen 3.5% in the year as of Thursday, beating 99% of the 856 diversified emerging-market funds, according to Morningstar.

Fewer than 2% of emerging-market stock funds tracked by the firm are up for the year, with the average fund down 9.4%.